Updated: WFC Is Still Undervalued

Wells Fargo Company (NYSE:WFC) is the fourth biggest bank in the U.S. by asset size and the largest by market capitalization. WFC can be considered a plain vanilla bank as it mostly derives its revenue from fee income and the interest spread between deposits and loans.

Overview:

The 6 main points regarding WFC

Diversified and stable revenue stream

Comparatively low funding cost

High RoA

Comparatively low leverage

Conservatively managed

Revenue growth

#1) Diversified and stable revenue stream:

WFC puts big emphasis on cross-selling its various products and thereby increasing their overall stickiness. The thinking is that the more products a client has with a bank, the more cumbersome/ inconvenient and hence unlikely it is that he or she will switch to another bank. Wells Fargo's cross-selling has grown from 4.6 products/ household in 2004 to 6.05 products/ household in 2012. Cross-selling products is very important as it not only creates a sort of moat for a bank but also enables it to collect more fees related to the various products which diversifies its revenue stream and makes it less dependent on interest rates. The make-up of noninterest income is also very important - WFC has only a small portion of net gains from trading, large account and service fees (which are very stable, "high quality" earnings), and a strong mortgage banking business (which is set to expand). Currently, ~50% of WFC's revenue is non-interest revenue ($43.2B net interest income vs. $42.9B noninterest income).

#2) Comparatively low funding cost:

WFC has very low funding costs and high deposits to total liabilities (meaning it has high quality funding). Deposits are the best kind of funding source as they are extremely low cost and very sticky, and WFC's strategic focus on cross-selling enables it to keep its customers even though it is offering the lowest interest rates as compared to competitors. This gives WFC a sort of pricing power in a commodity market (every bank offers basically the same checking and savings accounts, loans, etc.). In 2012, WFC's funding cost was ~39% lower than that of JPMorgan (NYSE:JPM) which had the next lowest funding cost within the group, yet it had a 9% deposit growth, so the low rates don't seem to be deterring depositors. WFC has beaten every of these 5 major competitors in terms of their funding cost in all but 1 of the last 14 years.

(click to enlarge)

*GS's deposits were negligible pre-2006 and cost of interest-bearing liabilities was not disclosed until 2006

#3&4) High RoA and comparatively low leverage

WFC has consistently had a far higher RoA than its competitors (in large part due to its lower funding costs) and can reasonably earn around ~1.4-1.5% (RoA) in a normalized environment - looking at 2012, that's 50% higher than JPM which has the next highest RoA within the group. WFC is also by far less leveraged than most of its competitors as can be seen at its leverage ratio.

(click to enlarge)

#5) Conservatively managed

WFC has historically mostly steered clear of industry hypes/ asset bubbles (e.g. late 1980s/ early 1990s highly leveraged transactions, 2003-07 interest only or amortizing loans and CDS frenzy). WFC had far lower net charge-offs post 2008 than its competitors despite purchasing Wachovia which had lots of bad loans mainly due to its Pick-a-Pay loan portfolio (the name says it all). WFC emerged out of the 2007/08 bubble burst far stronger than it was before as the Wachovia transaction added a lot of value. Based on WFC's normalized return on deposits which can (conservatively) be pegged at ~1.8-1.9% (for the year ended Dec.31 2012 it was at 1.87%), the Wachovia transaction added between $7.67B to $8.1B in earning power wherefore WFC snapped up Wachovia at a price of only ~3.5 - 3.7 times normalized earnings (for a total price of $23.1B + $5B in integration costs) and thereby grew its deposits by $426.2B to $781.4B (120% growth). Despite its size (WFC represents ~9.5% of U.S. deposits), WFC still managed to grow its deposits by 8.5% in 2011 and 9% in 2012 which is incredibly high.

(click to enlarge)

#6) Interest rate risk and growth:

WFC has a natural hedge against interest rate fluctuations as it is the largest U.S. mortgage originator. The 2012 10-K provides a breakdown of selected loans ($348.8B out of WFC's ~$800B portfolio) of which 89% of 1-5 year loans and 75% of 5+ year loans are variable rate. These loans will fluctuate with interest rates while WFC can further counter-act the pressure of increasing funding costs by keeping new loans (or MBS), originated at higher interest rates, on its books.

In preparation for the rebound of the mortgage market as well as other investment opportunities in a higher yield environment, WFC has ~$160B in cashand liquid short-term investments on hand which represents 11.9% of its assets (the second highest percentage in over 15 years). WFC also grew its home loan origination business in the past few years while its competitors, such as Bank of America (BAC), scaled back, which puts it in a great position for the rebounding mortgage market (mortgage applications in 2012 were $736B vs. $537B in 2011 - a 37% increase).

Free Cash Flow & Valuation:

(click to enlarge)

*The 2008 cap-ex was calculated as an average of the cap-ex in years 2004-2007 since the increase in 2008 increase in PPE was mostly due to the 2008 Wachovia acquisition which does not represent regular maintenance expenditure

WFC currently trades at around an 11.5 times P/ FCF multiple, implying an 8.7% equity yield. Based on 2012's FCF growth of 30%, which saw the beginning of a rebound in the mortgage market (mortgage banking sparked most of the FCF growth as it increased by ~$3.8B*) but still features a historically low NIM, there is substantial FCF growth ahead of WFC once the mortgage market thrives again and WFC starts to deploy some of the $160B in dry powder it has amassed at higher rates.

A 12-14% ROI (Pre-tax, reflecting div's and share price appreciation, assuming no multiple expansion) going forward is a reasonable assumption based on WFC's 8.7% equity yield and a continued ~3-5% FCF growth as the housing market expands and interest rates normalize (WFC's NIM is at an all-time low; while interest rate expansion will initially put further pressure on the NIM as funding sources adjust faster, it should over time rebound to more normal levels in the 4-6% range as it has been over the 40 years pre 2008).

Conclusion:

Wells Fargo is a very strong bank which by far outperforms its largest competitors in the most important areas. It has a strong, diversified noninterest revenue stream and low funding costs, both of which explain its high return on assets even in this low-yield environment. WFC has a very low leverage multiple and is a bank that focuses on the core business of a retail bank, that is, deposit taking and loan origination. At a P/FCF of 11.45 times and a P/B multiple of only 1.24 times (2 times would be more in line with historical values), WFC is still a cheap buy and has a lot of upside potential over the long-run when net interest margins normalize and the housing market fully recovers.

*This $3.8B increase is despite of a ~$1.9B mortgage repurchase liability (=provision), of which $1.7B was a belated bolster for 'low-quality' MBS sold pre 2008. This provision will fall off drastically over the near future as the allowance for pre 2008 MBS has been established and the MRL for 2012 and 2011 loans was only ~$0.1-0.2B (far higher quality loans require only a small provision), therefore freeing an additional ~$1.5B in income in the future

Disclosure: I am long WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you shortly for a conversation.

Thank you for your interest in Seeking Alpha PRO

Our PRO subscription service was created for fund managers, and the cost of the product is
prohibitive for most individual investors.
PRO Alerts is our flagship product for individual investors who want to be faster
and smarter about their stocks. To learn more about it, click here.
If you are an investment professional with over $1M AUM and received this message
in error, click here and you will be contacted shortly.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you when we have an individual investor product ready!